I have been talking a great deal lately about the Fed’s exit from its program of buying mortgage-backed securities (MBS). Over the last 13 months the Fed has spent more than one trillion dollars—that’s $1,000,000,000,000.00—to buy these securities in order to drive up their price, thereby artificially keeping interest rates low. This program has succeeded in keeping mortgage rates in a tight spread between 4.5 percent and 5.25 percent. The classic supply-and-demand formula is to drive higher demand for anything and the price will go up. (Price and yield are the inverse of each other, which is how mortgage rates are determined.)
Since the Fed is the biggest buyer of these securities, it constitutes a majority of demand for them. However, by the end of March the Fed will exit this program, leaving the demand to organic buyers in the market. If the classic law of supply and demand holds true, we should see the price of these securities fall when the Fed exits and demand falls. This fall in price will result in an increase on the yield side, thereby raising mortgage rates.
So, what does all this mean? Is it a truly black-and-white issue? Will rates jump 1 to 2 points in response to the Fed’s exit? Well, let’s look at it from an alternative perspective. Yes, it is true that rates will increase with the Fed’s exit; however, we may see organic market forces keeping those rates in check.
The Mortgage Bankers Association has predicted that mortgage applications will be down 40 percent for 2010. If we understand the purpose of MBS, we will have a better understanding of what may happen in the next 12 to 18 months to keep mortgage rates low.
The purpose of MBS is to help refund the market: Banks close on home loans with available cash, convert these loans into MBS, and sell them to investors, thereby re-funding their coffers so that they can fund more home loans. In fact, one of the main problems that mortgage banks had at the onset of the Great Mortgage Meltdown was a lack of liquidity. Investors stopped buying MBS, which cut off the flow of new money with which to fund new loans.
We know that the Fed is exiting its buying side and that demand should fall for MBS; but, if the Mortgage Bankers Association is correct that mortgage applications (closings) are going to be down for 2010, doesn’t it stand to reason that the supply of MBS for purchase will also fall? If supply falls in step with or right behind the fall in demand, we may not see such a huge increase in rates as the media would have us think.
Now, let’s throw into the mix some of the other government incentives and look at the resulting time line. Here is the way I see it panning out over the next 12 months: Because the homebuyer tax credit is set to expire this year on June 30, I believe that anyone who is thinking of buying a home in the next 12 months will use this window of opportunity to close before the tax credit expires. This means that any transactions that would normally happen in the later part of the summer and early part of the fall will move forward into late spring and early summer. Basically, we will be borrowing against future sales, which means that demand between now and June 30 will be inflated and that demand in the fall will be down.
What does this mean for the second half of the year? In my opinion, it means a huge decrease in demand for housing and a decrease in the supply of available MBS for purchase by investors. On a relevant note, most homeowners who could qualify for refinancing have already done so, which will lead to a large decrease in the number of refinance transactions for the year and, once again, reduce the supply of MBS for purchase.
The Fed is going to exit its program for buying mortgage-backed securities; and, as soon as this happens, we will see rates increase. However, once all the government incentives are gone from the market, we may see a rebound in mortgage rates to the lower side as supply comes into balance with demand. There are a couple of wild cards, however, that could derail my theory: (1) The Fed has left the window open to getting back into the market by making provision that it may from time to time as the market warrants purchase more MBS to keep the market stabilized. (2) (This may be the biggest threat.) With the midterm elections this November and as the bad news on the housing front reaches the media, the administration may create some other NON-organic incentive to help spur housing once again.
In this humble loan originator’s opinion, it is time to “yank the Band-Aid off” and let the market take care of itself. The longer the government tries to control the economy, the longer our healing time will be. As we can see, there are already fundamentals in place to, at the least, keep volatility both low and non-threatening. This is the question: Will they or won’t they?
Time will tell . . .
Supreme Lending – Austin
Great post John. So, you are saying you expect prices to fall later this year? How couldn’t they with no subsidy and rising Texas unemployment? Would it be prudent to wait until later this year to get property in Austin? Surely demand will be low then.
I agree that prices may fall some in the 2nd part of this year…however I don’t believe that that percentage will be greater than 5%, especially in the sub 300 price range. The problem with waiting until then is that rates could be as high as 2 points higher than they are now and that would mean that if you are financing your home then you could end up paying 10-15% more for it because of financing costs. I am currently writing an article that shows how this works and will post soon. If will have charts to back it up.
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